Financial Reporting Considerations: The UK’s Vote to Leave the EU

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The United Kingdom’s vote to depart from the European Union in its June 23 referendum (the “Brexit” vote) has given rise to a host of questions about the near-term and longer-term effects of Britain’s exit from the EU on an entity’s financial reporting.

The referendum itself will not result in the UK’s immediate exodus from the EU since the vote is not legally binding on the British government. Rather, Parliament, having heard the voice of voters, must now enact laws to facilitate the UK’s departure and must notify the European Commission of its intention to leave the EU. After such notice is provided, the UK and European Commission will have a two-year window in which to establish the terms of Britain’s departure.

Although formal separation from the EU will take time, the uncertainty introduced by the vote has already manifested itself in the financial markets. Such uncertainly is likely to affect other areas of the global economy in the short term and is expected to continue at least until the date on which the terms of the UK’s exit have been determined.

The impact on entities will vary significantly by industry sector and by other entity-specific factors. However, given the vote’s shock to global financial markets and their immediate reaction to it, all entities should consider how they are affected and what they may need to communicate to the market. The following are some near-term considerations:

—Typically, sharp rises in economic uncertainty express themselves initially and most forcefully through the liquidation of financial assets, which can significantly affect the value of currencies and drive down the value of equity securities. Flight by entities to safe-haven assets is also common. Overnight reports from foreign markets and trading activity in the United States on June 24, the day the Brexit referendum results were announced, suggest that these practices have already occurred and could affect many entities, including those that do not otherwise have significant exposure to the UK.

—In the UK corporate sector, the vote to leave the EU is likely to fuel perceptions of uncertainty and depress risk appetite. Lower risk appetite is likely, in turn, to lead to a squeeze in business investment and hiring in UK operations as well as a renewed focus on cash and cost control.

—Legal ramifications will take longer to become clear and will depend on the time frames associated with the terms of the EU departure agreement. However, for at least two years, EU regulations and EU-inspired UK laws will continue to apply.

Given the potentially significant and far-reaching effect of yesterday’s vote, entities should be aware of the following financial and regulatory reporting considerations as their next reporting cycle approaches:

—Risk factors: The vote may affect an entity’s risk factors, including new risks or changes to existing risks that may need to be disclosed. In an interim report, an entity’s disclosures may need to include more detail than the usual summary and reference to the risk factors included in the latest annual report.

—Accounting policies: In a volatile environment, management’s disclosure in MD&A of an entity’s accounting principles and its methods of applying those principles may be especially critical to an investor’s understanding of the entity’s financial statements. Further, entities should carefully consider the disclosure requirements in ASC 235-10-50-1 through 50-3* related to accounting policies disclosed in either their interim or annual financial statements.

—Impact of market volatility on assumptions and forecasts: Since short-term or longer term volatility is likely to affect key assumptions used in the development of forecasts, entities should identify which judgments and disclosures could be affected by the volatility. A good starting point would be an evaluation of the assumptions underlying the critical accounting policies disclosed in MD&A. Accounts that are most sensitive to financial market volatility may include investment balances, foreign currency denominated assets and liabilities, and other market-sensitive assets and liabilities. (See Appendix A in the full Financial Reporting Alert, below, for considerations related to selecting the appropriate exchange rate for translation of foreign currency transactions.)

—Impairment reviews: Market reaction to the vote may have triggered a requirement for entities to consider whether financial or nonfinancial assets (including goodwill and other intangible assets) are impaired. (See Appendix A in the full Financial Reporting Alert for impairment-related considerations.)

—Financial instrument considerations: Market reaction to the vote may affect, among other things, impairment assessments, classification of investment securities, hedge accounting and fair value measurement. (See Appendix A in the full Financial Reporting Alert for financial instrument considerations.)

—Income tax considerations: Market reaction to the vote may affect a reporting entity’s ability to use deferred tax assets or its ability to assert whether undistributed earnings of foreign subsidiaries will remain indefinitely invested. (See Appendix A in the full Financial Reporting Alert for tax considerations applicable to entities with foreign operations.)

—Inventory valuations: ASC 330 requires inventory to be measured at the lower of its cost or market value. In a volatile economic environment, it may be particularly important for an entity to challenge whether the utility of its inventory on hand has been impaired by changes in price levels or other causes. Entities should apply the guidance in ASC 330-10-35-1 through 35-11, which address adjustments of inventory balances to the lower of cost or market.

—Long-term intra-entity foreign investments: ASC 830 permits gains and losses on certain intra-entity foreign currency transactions “of a long-term investment nature” to be treated like translation adjustments instead of being recognized in net income. For a transaction to qualify as a long-term investment, an entity must be able to assert that “settlement is not planned or anticipated in the foreseeable future.” An entity that has characterized intra-entity transactions with entities in the UK or the EU as part of its net investment may need to reassess whether that designation is still appropriate. That is, the entity should reassess its assertion that settlement of intra-entity transactions is not planned or anticipated in the foreseeable future.

—Going concern: Economic changes, particularly those related to anticipated short-term cash flows in regions affected by the vote, may force entities to consider whether they should continue to prepare their financial statements on a going-concern basis. The flowchart in ASC 205-40-55-1 outlines a decision process for use in assessing whether substantial doubt exists about an entity’s ability to continue as a going concern and applies to both interim and annual financial statements.

—Disclosures: Entities should disclose how and why they have reached certain conclusions, in particular those related to forecasting or financing. SEC registrants should also consider the SEC reporting and disclosure considerations outlined in Appendix B in the full Financial Reporting Alert.

Because this massive change in the geopolitical landscape is still in its early days, the implications of the Brexit vote may not become clear until we see its effects on the capital markets and economy and start to understand the political timetable. Practice will no doubt evolve regarding the nature and quantity of disclosures that entities must provide in both interim reporting and annual reports.

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